Mergers And Acquisitions; Appraisal Rights
Unless they are a party to the transaction itself, such as in the case of a share-for-share exchange agreement, shareholders of a company in a merger transaction generally have what is referred to as “dissenters” or “appraisal rights.” An appraisal right is the statutory right by shareholders that dissent to a particular transaction, to receive the fair value of their stock ownership. Generally such fair value may be determined in a judicial or court proceeding or by an independent valuation. Appraisal rights and valuations are the subject of extensive litigation in merger and acquisition transactions. As with all corporate law matters, the Delaware legislature and courts lead the way in setting standards and precedence.
Delaware Statutory Appraisal Rights
Although the details and appraisal rights process vary from state to state (often meaningfully), as with other state corporate law matters, Delaware is the leading statutory example and the Delaware Chancery Court is the leader in judicial precedence in this area of law. More than half of U.S. public companies and more than two-thirds of Fortune 500 companies are domiciled in Delaware.
Moreover, as is consistent with all states, the Delaware General Corporation Law (“DGCL”) Section 262 providing for appraisal rights requires both petitioning stockholders and the company to comply with strict procedural requirements. The following is a high-level summary of the detailed procedures and process required by the company and stockholders where appraisal rights are available and where the stockholder desires to avail itself of such rights.
Except in share exchange transactions where all shareholders are a direct party to the transaction and transaction documents, stockholders of a corporation that is being acquired in a merger transaction have a statutory right to a court appraisal of the fair value of their shares. Dissenting stockholders may seek this judicial determination as an alternative to accepting the merger consideration being offered in the transaction negotiated by the company’s board of directors.
Section 262 of the DGCL gives any stockholder of a Delaware corporation who (i) is the record holder of shares of stock on the date of making an appraisal rights demand, (ii) continuously holds such shares through the effective date of the merger, (iii) complies with the procedures set forth in Section 262, and (iv) has neither voted in favor of nor consented in writing to the merger, to seek an appraisal by the Court of Chancery of the fair value of their shares of stock.
Where an action allowing for appraisal rights is to be voted on by stockholders, the corporation must give written notice to its stockholders as of the meeting notice record date, not less than 20 days prior to the meeting. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must (i) deliver a written demand to the company for appraisal prior to the taking of the stockholder vote on the merger (or, in the case of a short-form merger or a merger approved by a written consent of stockholders, within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger), (ii) file a petition with the Delaware Court of Chancery within 120 days after the effective date of the merger, and (iii) serve a copy of such petition on the corporation surviving the merger. Within 10 days of the effective date of the merger, the surviving corporation must give each stockholder that has elected appraisal rights, and not thereafter voted for or consented to the merger, notice of such merger effective date.
Where an action allowing for appraisal rights is approved without a vote by stockholders, within 10 days of the approval the corporation shall notify each of the stockholders who are entitled to appraisal rights of the approval of the merger and that appraisal rights are available. If already completed, the notice shall include the effective date of the merger. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must deliver a written demand to the company for appraisal within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger. Thereafter the same procedures will apply as when approval was by a vote of stockholders.
At the hearing the court will determine the stockholders that have properly complied with the statute and are entitled to appraisal rights. Once it is determined which stockholders are entitled to an appraisal, the court will proceed with the substantive process of determining fair value. The statute requires that in determining such fair value, the court shall take into account all relevant factors (see the discussion below regarding the substantive fair value determinations).
Unless the court has good cause and determines otherwise, interest of 5% above the Federal Reserve discount rate shall accrue on the fair value of the shares from the date of the merger until the date paid. The court also has the statutory right to grant or deny the recovery of attorney’s fees and costs to a petitioning shareholder. From and after the effective date of the merger, stockholders who have demanded appraisal rights are not entitled to vote their shares or to receive any dividends or other distributions (including the merger consideration) on account of these shares unless they properly withdraw their demand for appraisal.
Dependent on the consideration to be received, appraisal rights are not available for (i) shares of the corporation surviving the merger if the merger does not require the approval of the stockholders of such corporation and (ii) shares of any class or series that is listed on any national security exchange or held of record by more than 2,000 holders. In particular, these exceptions do not apply if the holders of such shares are required to accept in the merger any consideration other than (i) shares of stock of the corporation surviving or resulting from the merger or consolidation, (ii) shares of stock of any other corporation that will be listed on a national securities exchange or held of record by more than 2,000 holders, (iii) cash in lieu of fractional shares, or (iv) any combination of the foregoing. In addition, these exceptions do not apply in respect of shares held by minority stockholders that are converted in a short-form parent subsidiary merger.
Section 262 of the DGCL also allows for a corporation to include in its certificate of incorporation the same merger appraisal rights for (i) amendments to the certificate of incorporation and (ii) the sale of all or substantially all of the assets of the corporation.
Determining Fair Value; The Longpath and Merion Capital Cases
On October 21, 2015, in Merion Capital LP v. BMC Software, Inc., the Delaware Court of Chancery rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. The Merion opinion is consistent with the June 30, 2015, Delaware Court of Chancery opinion which also rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. In Merion Capital and Longpath Capital, LLC v. Ramtron Int’l Corp., the Delaware court continued its recent consistent record of upholding the merger price as the most reliable indicator of fair value where the merger price was reached after a fair and adequate process in an arm’s length transaction. In this case, the merger price followed several rejected bids, an active solicitation of other potential buyers, and a three-month hard bargaining process.
Generally there are four recurring valuation techniques used in an appraisal rights proceeding: (i) the discounted cash flow (DCF) analysis; (ii) a comparable company’s analysis and review; (iii) a comparable transactions analysis and review and (iv) the merger price itself. Merger price is usually reached through the reality of a transaction process, as opposed to the academic and subjective valuation processes used in litigation challenging such price. Courts unanimously give greater, and usually 100%, weight to the merger price where the merger negotiation process was adequate.
Where there is a question as to the process resulting in the final merger price, Delaware courts generally look to the DCF analysis as the next best indicator of fair value. In this case, the court rejected the DCF analysis presented by the parties’ experts in the litigation as based on unreliable management projections. Although a DCF analysis is often used in litigation to challenge the merger price, as with the Longpath case, the Delaware courts will not give much weight to a DCF model based on management-prepared projections where such projections are prepared outside the ordinary course of business such as in response to a hostile takeover bid, other potential transaction or for use in litigation. Moreover, even where management projections are prepared in the ordinary course, the courts will consider the process used, assumptions made and the experience of management in preparing such projections as well as other qualitative and quantitative standards as to their reliability.
In addition to being skeptical regarding the weight to be given a DCF analysis, courts will likewise be skeptical regarding comparable transactions. In reviewing comparable transactions, courts will consider the types of companies involved, multiples used in each industry, and basic business realities.
Prior to the recent slew of cases upholding merger price as the best indication of value, the seminal case on appraisal rights was Weinberger v. UOP, 457 A.2d 701 (Del. 1983), which held that a proper valuation approach “must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.” The Weinberger court also held that the valuation should include elements of future value that are known or susceptible to proof, excluding only speculative elements. Following Weinberger the DCF model gained in popularity with the Delaware courts. As discussed above, recently the DCF model has been losing ground in favor of the merger price itself where the price is achieved following a fair and adequate process in an arm’s length transaction.
Managing Risks Associated with Appraisal Rights
The best way to manage risks associated with the appraisal process, and all aspects of the merger itself, is to pay meticulous attention to the process. The board of directors should utilize legal and financial advisors and delve into information gathering, analytical and deliberative processes and the manner in which they are documented in order to ensure that a defensible record is produced. See also my blog related to directors’ responsibilities in the merger process and the importance of the process itself, HERE.
Careful attention must be paid to the disclosure documents provided to stockholders related to the transaction. The document should include a thorough description of all relevant facts that support the fairness of the merger consideration. Relevant facts include, among other matters, historical operating results and future prospects, competitive and other risks, levels of liquidity and capital resources, internal and external indicia of value, efforts to explore strategic alternatives and the results thereof, opportunities for interested parties to submit competing acquisition proposals, and fairness opinions obtained from financial advisors and supporting analyses. Of course, as with all anti-fraud considerations, the document cannot misstate or omit material facts and information.
Hedging in Merger Transactions
There has been a recent dramatic increase in appraisal rights actions filed by shareholders that purchase shares after the record date of the relevant transaction. That is, it appears that a group of investors are hedging on merger transactions and utilizing the appraisal process as part of their hedging strategy. An interesting paper and analysis by the The Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Appraisal Arbitrage – Is There a Delaware Advantage” sets forth a well thought out theory as to why this investment strategy may be profitable to arbitrageurs. Here is a brief summary of the theory and for those interested in learning more about this theory, I encourage reading the entire paper.
First, Delaware allows shareholders to pursue appraisal rights even if they purchase shares after the record date for voting on the transaction. Investors can delay their investment decision until they have a better idea of valuation of the target. Moreover, by delaying the investment decision to as close as possible to the closing date, investors can minimize or even eliminate the risk that the deal will not close.
Second, many courts give preference to the DCF analysis valuation method. However, investment bankers advising on M&A deals tend to be more conservative. The paper points out that in a review of sample deals, nearly two-thirds of the time there was a differential between valuation used by investment bankers in providing fairness opinions to parties in an M&A transaction and fair values determined by the Delaware Courts. Investors have an opportunity to take advantage of this spread.
Third, the Delaware statute requires the court to determine a point estimate rather than a range of fair value. Accordingly, transactions completed at the low end of the DCF value range have a greater chance of a court determining that the fair value is higher, even if only by a few points.
Finally, the Delaware statutory rate for successful petitioner in an appraisal rights action is higher than the current yield on U.S. Treasury Bonds, thus creating a potential economic incentive for arbitrageurs.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the producer and host of LawCast, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington D.C., Denver, Tampa, Detroit and Dallas.
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Reverse Merger Attorney
What is a reverse merger? What is the process?
A reverse merger is the most common alternative to an initial public offering (IPO) or direct public offering (DPO) for a company seeking to go public. A “reverse merger” allows a privately held company to go public by acquiring a controlling interest in, and merging with, a public operating or public shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of any amount of cash and cash equivalents.
In a reverse merger process, the private operating company shareholders exchange their shares of the private company for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the private operating company own a majority of the public company and the private operating company has become a wholly owned subsidiary of the public company. The pre-closing controlling shareholder of the public company either returns their shares to the company for cancellation or transfers them to individuals or entities associated with the private operating business. The public company assumes the operations of the private operating company. At the closing, the private operating company has gone public by acquiring a controlling interest in a public company and having the public company assume operations of the operating entity.
A reverse merger is often structured as a reverse triangular merger. In that case, the public shell forms a new subsidiary which new subsidiary merges with the private operating business. At the closing the private company, shareholders exchange their ownership for shares in the public company and the private operating business becomes a wholly owned subsidiary of the public company. The primary benefit of the reverse triangular merger is the ease of shareholder consent. That is because the sole shareholder of the acquisition subsidiary is the public company; the directors of the public company can approve the transaction on behalf of the acquiring subsidiary, avoiding the necessity of meeting the proxy requirements of the Securities Exchange Act of 1934.
The SEC requires that a public company file Form 10 type information on the private entity within four days of completing the reverse merger transaction (a super 8-K). Upon completion of the reverse merger transaction and filing of the Form 10 information, the once private company is now public. Form 10 information refers to the type of information contained in a Form 10 Registration Statement. Accordingly, a Super 8-K is an 8-K with a Form 10 included therein.
Like any transaction involving the sale of securities, the issuance of securities to the private company shareholders must either be registered under Section 5 of the Securities Act or use an available exemption from registration. Generally, shell companies rely on Section 4(a)(2) or Rule 506 of Regulation D under the Securities Act for such exemption.
The Transaction
A reverse merger is a merger transaction with the difference being that the target ultimately ends up owning a majority of the acquirer. However, the documentation and process to complete the transaction is substantially the same as a forward merger.
Generally the first step in a reverse merger is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.
In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.
Next is the letter of intent (“LOI”). An LOI is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with a “who do” identification.
Following the LOI, the parties will prepare a definitive agreement which is generally titled either a “Share Exchange Agreement” or a “Merger Agreement.” In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.
The main components of the Merger Agreement and a brief description of each are as follows:
1. Representations and Warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The seller also represents and warrants its legal ability to enter into the agreement.
2. Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that the private company must continue to operate the business in the ordinary course and maintain assets pending closing and if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.
3. Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
4. Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
5. Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.
6.In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no-shop provisions, breakup fees, and/or non-compete and confidentiality provisions if not previously agreed to separately.
The next and final steps are the actual closing in which the shares of stock and reverse merger consideration change hands and a Super 8-K is filed with the SEC.
Reverse Merger Consideration/The Cost of the Shell
In a reverse merger transaction, the private operating business must pay for the public shell company. That payment may be in cash, equity or both. Although the cash price of shell entities can vary and changes over time as does the value of all assets, as of the day of this blog, the average cash value of a fully reporting public entity with no liabilities, no issues (such as a DTC chill) and which is otherwise “clean” is between $280,000 – $400,000. The price variance depends on many factors, such as pre- and post-closing conditions (such as a requirement that the public entity complete a name change and/or stock split prior to closing); the ultimate percent ownership that will be owned by the private operating company shareholders; how quickly the transaction can close; whether the private entity has its “ducks in a row” (see below); whether the entities have complete due diligence packages prepared; and whether any broker-dealers or investment bankers must be paid in association with the transaction.
Where the private operating business is paying for the public shell entity with equity, the current shareholders of the public shell company keep a larger portion of their pre-closing equity and therefore own a greater percent of the new combined companies post-closing. That is, the current public company shareholders have a lower level of dilution in the transaction.
For example, in a cash reverse merger transaction, generally the current control shareholders of the public company cancel or otherwise divest themselves of all of their share ownership and the post-closing share ownership is anywhere from 80%/20% to 99%/1% with the private operating company shareholders owning the majority. In an equity transaction, the current control shareholders keep some or all of their current share ownership. In addition, the final post-closing capitalization will generally be anywhere from 51%/49% to 80%/20% with the private operating company shareholders owning the majority.
The percentage of ownership maintained by the public company shareholders will depend on the perceived value of the private operating company and an expectation of what the value of their share ownership could be in the future. Clearly there is risk involved for the public company shareholders. That is, control shareholders may have to decide whether to accept $300,000 today or maintain a stock ownership level that they hope will be worth much more than that at some time in the future. From the private operating company’s perspective, they are diluting their current ownership and giving up a piece of the pie.
Accordingly, in an equity transaction, the parties to the reverse merger will negotiate the value of the private operating business. For business entities with operating history, revenue, profit margins and the like, valuation is determined by mathematical calculations and established mathematically based matrixes (usually 1x to 8x EBITDA). For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist. In this case, valuation is based on negotiation and a best guess.
Establishing valuation for a development stage or start-up entity ultimately comes down to an investor’s (i.e., in a reverse merger, public company shareholders who agree to forgo cash and keep equity instead) perception of risk versus reward. Risk is easy to determine: If I could get $300,000 cash for the public shell today, I may lose that $300,000 by accepting equity instead. Reward, on the other hand, is an elusive prospect based on the potential success of a business.
In determining value, an analysis (due diligence) should be conducted on a minimum of the following: market data; competition; pricing and distribution strategies; assets and liabilities; hidden liabilities; inflated assets; technology risks; product development plans; legal structure; legal documentation; corporate formation documents and records; and management, including backgrounds on paper, and face-to-face assessments.
Areas of Consideration in Determining Valuation
The following areas should be researched and considered in valuation. The below list is in no particular order.
1. Investment comps: Have investors, either private or public, recently funded similar companies, and if so, on what terms and conditions and at what valuation;
2. Market Data: What is the product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;
3. Competition: Who are the major competitors; what is their valuation; how does this company differ from these competitors;
4. Uniqueness of product or technology: How is the product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;
5. Pricing and Distribution Strategies: What are the major impediments to successful entry into the marketplace; what is the plan for successful entry into the marketplace; has order fulfillment, including transportation costs, been considered; connections to end users for the product or service; what are profit margins and will the margins increase as the business grows and scales;
6. Capital investments to date: What capital investments have been made to the company to date, including both financial and services;
7. Assets and liabilities: What does the balance sheet look like; are there hidden liabilities; any off-balance sheet arrangements; how are assets valued; are any assets either over- or undervalued; is there clear title to all assets;
8. Technology Risks: What technologies are relied upon; what is the state of evolvement of those technologies; can they keep up;
9. Product Development Plans: Are there a model and samples; have they been tested; have manufacturing channels been established; exclusive contracts with manufacturers; what is the overall plan to bring the product to market and subsequently become a competitor in the industry;
10. Legal Structure: Legal structure of current outstanding equity – just common equity or common and preferred, and if preferred, what rights are associated therewith (redemption rights; liquidation preferences; dividends; voting rights);
11. Legal documentation: Not only whether corporate records are in order, but are all contracts and arrangements properly documented;
12. Future financing needs: Will significant future financing be necessary to achieve the business plan; what is the risk of a future down round (note that a down round is a future financing at a lower valuation resulting in dilution to the current investors);
13. Exit strategies: How will the current shareholder be able to sell; will the shares have piggyback or demand registration rights; reliance on Rule 144?; lockup or other additional holding periods?;
14. Management: This is perhaps the most important consideration – Does the management team have a proven history of success; prior business experience in this and other industries; work ethic; general management skills; organization skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face-to-face discussions;
16. Developmental milestones: Has the company achieved its developmental milestones to date?
Advantages of a Reverse Merger
The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete the paperwork. Having your “ducks in a row” includes having completed audited financial statements for the prior two fiscal years and quarters up to date (or from inception if the company is less than two years old), and having the information that will be necessary to file with the SEC readily available. The reverse merger transaction itself is not a capital-raising transaction, and accordingly, most private entities complete a capital-raising transaction (such as a PIPE) simultaneously with or immediately following the reverse merger, but it is certainly not required. In addition, many companies engage in capital restructuring (such as a reverse split) and a name change either prior to or immediately following a reverse merger, but again, it is not required.
Raising money is difficult and much more so in the pre-public stages. In a reverse merger, the public company shareholders become shareholders of the operating business and no capital raising transaction needs to be completed to complete the process. Accordingly, companies that may be less mature in their development and unable to attract sophisticated capital financing can use a reverse merger to complete a going public transaction and still benefit from being public while they grow and mature. Such benefits include the ability to use stock and stock option plans to attract and keep higher-level executives and consultants and to make growth acquisitions using stock as currency.
Disadvantages of a Reverse Merger
There are several disadvantages to a reverse merger. The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is unavailable for the use by shareholders of any company that is or was at any time previously a shell company unless certain conditions are met. In order to use Rule 144, a company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company – then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.
Rule 144 now affects any company that was ever in its history a shell company by subjecting them to additional restrictions when investors sell unregistered stock under Rule 144. The new language in Rule 144(i) has been dubbed the “evergreen requirement.” Under the so-called “evergreen requirement,” a company that ever reported as a shell must be current in its filings with the SEC and have been current for the preceding 12 months before investors can sell unregistered shares.
Another disadvantage concerns undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell. The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger, although generally, capital-raising transactions are much easier to access once public. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both. However, it should be noted that an IPO or DPO is also costly.
In addition, the NYSE, NYSE MKT (formerly AMEX) and NASDAQ exchanges have enacted more stringent listing requirements for companies seeking to become listed following a reverse merger with a shell company. The rule change prohibits a reverse merger company from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, new rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report. The new rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes some exceptions for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.
Finally, whether an entity seeks to go public through a reverse merger or an IPO, they will be subject to several, and ongoing, time-sensitive filings with the SEC and will thereafter be subject to the disclosure and reporting requirements of the Securities Exchange Act of 1934, as amended.
The Author
Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
Corporate and Securities Attorney Laura Anthony’s legal expertise includes but is not limited to registration statements, including Forms S-1, S-4, S-8 and Form 10, PIPE transactions, debt and equity financing transactions, private placements, reverse mergers, forward mergers, asset acquisitions, joint ventures, crowdfunding, and compliance with the reporting requirements of the Securities Exchange Act of 1934 including Forms 10-Q, 10-K and 8-K, the proxy requirements of Section 14, Section 16 filings and Sarbanes-Oxley mandated policies. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
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Mergers and Acquisitions; Merger Documents Outlined
An Outline Of the Transaction
The Confidentiality Agreement
Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.
In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.
The Letter of Intent
Next is the letter of intent (“LOI”). An LOI is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with a “who do” identification.
Many clients ask me how to protect their interests while trying to negotiate a merger or acquisition. During the negotiation period, both sides will incur time and expense, and will provide the other with confidential information. The way to protect confidential information is through a confidentiality agreement, but that does not protect against wasted time and expense. Many other protections can be used to avoid wasted time and expense.
Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. That period of time may be set in calendar time, such as sixty days, or based on conditions, such as completion of an environmental study, or a combination of both.
A “window shop” provision allows for some level of third-party negotiation or inquiry. An example of a window shop provision may be that a party cannot solicit other similar transactions but is not prohibited from hearing out an unsolicited proposal. A window shop provision may also allow the board of directors of a party to shop for a better deal, while giving a right of first refusal if such better deal is indeed received. Window shop provisions generally provide for notice and disclosure of potential “better deals” and either matching or topping rights.
Generally, both no shop and window shop provisions provide for a termination fee or other detriment for early termination. The size of the termination fee varies; however, drafters of a letter of intent should be cognizant that if the fee is substantial, it likely triggers a reporting and disclosure requirement, which in and of itself could be detrimental to the deal.
Much different from a no shop or window shop provision is a “go shop” provision. To address a board of directors’ fiduciary duty and, in some instances, to maximize dollar value for its shareholders, a potential acquirer may request that the target “go shop” for a better deal up front to avoid wasted time and expense. A go shop provision is more controlled than an auction and allows both target and acquiring entities to test the market prior to expending resources.
Another common deal protection is a standstill agreement. A standstill agreement prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning of subsidiaries, hiring or firing management teams and the like.
Finally, many companies protect their interests by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.
The Merger Agreement
In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being purchased and provides for rights and remedies in the event that this description proves to be materially inaccurate. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.
The main components of the Merger Agreement and a brief description of each are as follows:
Representations and Warranties – representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The Seller also represents and warrants its legal ability to enter into the agreement.
Covenants – covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing and if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.
Conditions – conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
Indemnification/remedies – indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.
In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no shop provisions, breakup fees, non-compete and confidentiality provisions if not previously agreed to separately.
Disclosure Matters
In a merger or acquisition transaction, there are three basic steps that could invoke the disclosure requirements of the federal securities laws: (i) the negotiation period or pre-definitive agreement period; (ii) the definitive agreement; and (iii) closing.
(i) Negotiation Period (Pre-Definitive Agreement)
Generally speaking, the federal securities laws do not require the disclosure of a potential merger or acquisition until such time as the transaction has been reduced to a definitive agreement. Companies and individuals with information regarding non-public merger or acquisition transactions should be mindful of the rules and regulations preventing insider trading on such information. However, there are at least three cases where pre-definitive agreement disclosure may be necessary or mandated.
1. The first would be in the Management, Discussion and Analysis section of a Company’s quarterly or annual report on Form 10-Q or 10-K respectively.
Item 303 of Regulation S-K which governs the disclosure requirement for Management’s Discussion and Analysis of Financial Condition and Results of Operations requires, as part of this disclosure that the registrant identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. Furthermore, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the Instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”
It seems pretty clear that a potential merger or acquisition would fit firmly within the required MD&A discussion. However, realizing that disclosure of such negotiations and inclusion of such information could, and often would, jeopardize completing the transaction at all, the SEC has provided guidance. In SEC Release No. 33-6835 (1989), the SEC eliminated uncertainty regarding disclosure of preliminary merger negotiations by confirming that it did not intend for Item 303 to apply, and has not applied, and does not apply to preliminary merger negotiations. In general, the SEC’s recognition that companies have an interest in preserving the confidentiality of such negotiations is clearest in the context of a company’s continuous reporting obligations under the Exchange Act, where disclosure on Form 8-K of acquisitions or dispositions of assets not in the ordinary course of business is triggered by completion of the transaction (more on this below). Clearly, this is a perfect example and illustration of the importance of having competent legal counsel assist in interpreting and unraveling the numerous and complicated securities laws disclosure requirements.
In contrast, where a company registers securities for sale under the Securities Act, the SEC requires disclosure of material probable acquisitions and dispositions of businesses, including the financial statements of the business to be acquired or sold. Where the proceeds from the sale of the securities being registered are to be used to finance an acquisition of a business, the registration statement must disclose the intended use of proceeds. Again, accommodating the need for confidentiality of negotiations, registrants are specifically permitted not to disclose in registration statements the identity of the parties and the nature of the business sought if the acquisition is not yet probable and the board of directors determines that the acquisition would be jeopardized. Although beyond the scope of this blog, many merger and/or acquisition transactions require registration under Form S-4.
Accordingly, where disclosure is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the company’s view, inclusion of such information would jeopardize completion of the transaction. Where disclosure is otherwise required or has otherwise been made by or on behalf of the company, the interests in avoiding premature disclosure no longer exist. In such case, the negotiations would be subject to the same disclosure standards under Item 303 as any other known trend, demand, commitment, event or uncertainty.
2. The second would be in Form 8-K, Item 1.01 Entry into A Material Definitive Agreement.
Yes, this is in the correct category; the material definitive agreement referred to here is a letter of intent or confidentiality agreement. Item 1.01 of Form 8-K requires a company to disclose the entry into a material definitive agreement outside of the ordinary course of business. A “material definitive agreement” is defined as “an agreement that provides for obligations that are material to and enforceable against the registrant or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions.” Agreements relating to a merger or acquisition are outside the ordinary course of business. Moreover, although most letters of intent are non-binding by their terms, many include certain binding provisions such as confidentiality provisions, non-compete or non-circumvent provisions, no-shop and exclusivity provisions, due diligence provisions, breakup fees and the like. On its face, it appears that a letter of intent would fall within the disclosure requirements in Item 1.01.
Once again, the SEC has offered interpretative guidance. In its final rule release no. 33-8400, the SEC, recognizing that disclosure of letters of intent could result in destroying the underlying transaction as well as create unnecessary market speculation, specifically eliminated the requirement that non-binding letters of intent be disclosed. Moreover, the SEC has taken the position that the binding provisions of the letter, such as non-disclosure and confidentiality, are not necessarily “material” and thus do not require disclosure. However, it is important that legal counsel assist the company in drafting the letter, or in interpreting an existing letter to determine if the binding provisions reach the “materiality” standard and thus become reportable. For example, generally large breakup fees or extraordinary exclusivity provisions are reportable.
3. The third would be in response to a Regulation FD issue.
Regulation FD or fair disclosure prevents selective disclosure of non-public information. Originally Regulation FD was enacted to prevent companies from selectively providing information to fund managers, big brokerage firms and other “large players” in advance of providing the same information to the investment public at large. Regulation FD requires that in the event of an unintentional selective disclosure of insider information, the company take measures to immediately make the disclosure to the public at large through both a Form 8-K and press release.
(ii) The Definitive Agreement
The definitive agreement is disclosable in all aspects. In addition to inclusion in Form 10-Q and 10-K, a definitive agreement must be disclosed in Form 8-K within four (4) days of signing in accordance with Item 1.01 as described above. Moreover, following the entry of a definitive agreement, completion of conditions, such as a shareholder vote, will require in-depth disclosures regarding the potential target company, including their financial statements.
(iii) The Closing
The Closing is disclosable in all aspects, as is the definitive agreement. Moreover, in addition to item 1.01, the Closing may require disclosures under several or even most of the Items in Form 8-K, such as Item 2.01 – Completion of disposal or acquisition of Assets; Item 3.02 – Unregistered sale of securities; Item 4.01 – Changes in Certifying Accountant; Item 5.01 Change in Control, etc.
The Author
Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms.
Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
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